February 6, 2008

Pricing Risk II

Risk planning, in my opinion, is the only thing investment should be about. Success in investment is about risk management and assessment more so than picking good ideas. In my view there are 4 types of risk:

  1. Business specific risks: where you lose because of management incompetence, increased competition, and financial insolvency.
  2. Valuation risk: there is an adage that says "not all good companies make good investment". This means that you can find an absolutely great management, fantastic product, great prospect, and good sustainable competitive advantage. So where is the risk? The company is overvalued by investors leaving no room for good return and little margin for error.
  3. Systemic risks: these risks are general economic risks that are not unique to one company but rather impact most companies to one degree or another.
  4. Your own liquidity risk: there may be circumstances that could force you to sell great undervalued businesses prematurely at depressed market prices, therefore you realize losses.
All of these risks are present in any investment you make. Realizing their existence and planning for them is as important as researching and analyzing any business idea.

Risks # 1 and # 2 are under your control entirely by performing prudent due diligence you can eliminate these risks. Some will argue diversification can illuminate them as well, sure it can but it comes at the expense of your portfolio performance. I would rather invest my time to analyze and research one great company rather than buy two average businesses. And to avoid #2 simply do not overpay. Avoid companies that are in the headlines news or the ones that your annoying brother in law recommends to you.

Risk # 3 is outside of your control but you can plan for it nonetheless. You can have a good asset allocation mix between equities, bonds, and real estate to diversify this risk as generally in rescissions bonds tend to do better than equities.

Risk # 4 sometime no matter how you plan for it, it will happen but again you can minimize this by only investing the sum of money that you can do without for indefinite amount of time. You should not invest if you are running a startup business, or your foresee you need capital for an upcoming financial obligation. Any investment should be made with the assumption it is forever.

Risk and investment is two faced coin. You have to be able manage both well to succeed.

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